Tighter market regulation combined with a nuanced approach to building a multilayered capital market has accelerated China's attempts to provide easier financial services, especially funding, to technology companies as well as growth-oriented small and medium-sized enterprises in emerging or strategic sectors, market insiders said.

While tighter regulation will help improve the quality of IPOs as well as provide easier exit route for early-stage investors (like private equity or PE firms) in startups, there are two other relatively recent and related developments that have brought glad tidings to the market in the last few months: the rapid growth of secondary funds, or S funds; and the establishment of a new board for small and medium-sized enterprises specializing in niche sectors.

Together, these have the potential to significantly reshape China's capital market, experts said.

S funds enable their investors to purchase equity in unlisted firms funded by PE firms; they can also buy limited-partnership interests in PE firms themselves. Their growth offers reassurance that PE firms can easily exit their primary investments (startups), which is said to encourage more PE investments in startups.

There have been a slew of S fund launches in recent months. In early May, six State-owned enterprises in Southwest China's Sichuan province poured in 1.5 billion yuan ($207 million) to set up the province's first S fund. The aim is to seek investment opportunities in strategic sectors like electronic information, biomedicine, new energy, artificial intelligence and advanced manufacturing.

In mid-April, East China's Anhui province completed registration of a 2.8 billion yuan S fund as part of its broader effort to build a multilayered capital market.

Shanghai, the financial hub of China, of course, leads the S fund pack. Shanghai International Group or SIG, the investment arm for State-owned assets in the city, unveiled a 10 billion yuan S fund in late April. Less than a year back, SIG had initiated a 1.5 billion yuan S fund, the first of its kind launched by SOEs in the city.

Zheng Siyuan, a Shanghai-based partner in market consultancy Bain& Co's Greater China PE practice, attributed the proliferation of S funds to the tightening regulatory grip on IPOs.

Zheng said an S fund can be seen as PE firms' trading in the secondary market. This segment has, at times since 2022, overtaken direct investment in the primary market. A few common practices have since emerged: a limited partner (or capital provider) directly transfers his equity stake to another general partner (or fund manager); or one GP sells some of his/her assets to another GP.

Apart from providing an exit channel for PE firms, S funds can serve as a "relay mechanism "between the primary market and the stock market by coming up with various products and professional practices, said Yang Bin, president of the Shanghai Science and Technology Innovation Fund, the manager of the newly launched 10 billion yuan S fund in Shanghai.

In this sense, S funds can help better connect technology companies with providers of financial services and industrial capital, he said.

The municipal government of Shanghai is well aware of the importance of S funds, which are indispensable in building a multilevel capital market. In September 2022, an S fund alliance was formed in Shanghai, comprising more than 80 leading securities firms, banks and funds of funds from home and abroad.

At the beginning of this year, Shanghai introduced a set of 32 measures to facilitate the high-quality development of equity investment. Among them, the development of S funds in the city was stressed.

Banks' asset management subsidiaries, insurers, trusts and State-owned funds of funds are encouraged to step up their investment in S funds and ensure their expansion. This is part of the city's efforts to better serve the real economy and stimulate technology innovation by giving more play to equity investment, according to the government document.

Data from Beijing-based PE services platform FOF Weekly showed that the total trading value of China's S funds was around 60 billion yuan in 2023. Globally, the trading size surged rapidly to over 112 billion yuan last year from only 22 billion yuan in 2010.

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